Académique Documents
Professionnel Documents
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S U P P L E M E N T
F I N A N C I A L A N A LY S I S
Vol. VI Valuation of
Operations at ABTco
CONCEPTS
AND
Cros
unction
sF
al
In this supplement we review basic concepts and tools of financial analysis for OM. These
include the types of cost (fixed, variable, sunk, opportunity, avoidable), risk and expected
value, and depreciation (straight line, sum-of-the-years-digits, declining balance, doubledeclining balance, and depreciation-by-use). We also discuss activity-based costing and
cost-of-capital calculations. Our focus is on capital investment decisions.
DEFINITIONS
EXHIBIT SB.1
Fixed and Variable Cost
Components of Total Cost
Total cost
Variable cost
Fixed cost
Production
cost
Units of output
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Suppose a firm has $100,000 to invest, and two alternatives of comparable risk present
themselves, each requiring a $100,000 investment. Investment A will net $25,000; Investment B will net $23,000. Investment A is clearly the better choice, with a $25,000 net
return. If the decision is made to invest in B instead of A, the opportunity cost of B is
$2,000, which is the benefit forgone.
A v o i d a b l e C o s t s Avoidable costs include any expense that is not incurred if an
investment is made but that must be incurred if the investment is not made. Suppose a company owns a metal lathe that is not in working condition but is needed for the firms operations. Because the lathe must be repaired or replaced, the repair costs are avoidable if a new
lathe is purchased. Avoidable costs reduce the cost of a new investment because they are
not incurred if the investment is made. Avoidable costs are an example of how it is possible
to save money by spending money.
E x p e c t e d V a l u e Risk is inherent in any investment because the future can never be
predicted with absolute certainty. To deal with this uncertainty, mathematical techniques
such as expected value can help. Expected value is the expected outcome multiplied by the
probability of its occurrence. Recall that in the preceding example the expected outcome of
Alternative A was $25,000 and B, $23,000. Suppose the probability of As actual outcome is
80 percent while Bs probability is 90 percent. The expected values of the alternatives are
determined as follows:
Expected Probability that actual Expected
outcome outcome will be the = value
expected outcome
Investment A: $25,000 0.80 = $20,000
Investment B: $23,000 0.90 = $20,700
Investment B is now seen to be the better choice, with a net advantage over A of $700.
E c o n o m i c L i f e a n d O b s o l e s c e n c e When a firm invests in an incomeproducing asset, the productive life of the asset is estimated. For accounting purposes, the
asset is depreciated over this period. It is assumed that the asset will perform its function
during this time and then be considered obsolete or worn out, and replacement will be
required. This view of asset life rarely coincides with reality.
Assume that a machine expected to have a productive life of 10 years is purchased. If at
any time during the ensuing 10 years a new machine is developed that can perform the same
task more efficiently or economically, the old machine has become obsolete. Whether or
not it is worn out is irrelevant.
The economic life of a machine is the period over which it provides the best method for
performing its task. When a superior method is developed, the machine has become obsolete. Thus, the stated book value of a machine can be a meaningless figure.
D e p r e c i a t i o n Depreciation is a method for allocating costs of capital equipment.
The value of any capital assetbuildings, machinery, and so forthdecreases as its useful
life is expended. Amortization and depreciation are often used interchangeably. Through
convention, however, depreciation refers to the allocation of cost due to the physical or functional deterioration of tangible (physical) assets, such as buildings or equipment, whereas
amortization refers to the allocation of cost over the useful life of intangible assets, such as
patents, leases, franchises, and goodwill.
Depreciation procedures may not reflect an assets true value at any point in its life because obsolescence may at any time cause a large difference between true value and book
value. Also, because depreciation rates significantly affect taxes, a firm may choose a particular method from the several alternatives with more consideration for its effect on taxes
than its ability to make the book value of an asset reflect the true resale value.
Next we describe five commonly used methods of depreciation.
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STRAIGHT-LINE METHOD
Under this method, an assets value is reduced in uniform annual amounts over its estimated
useful life. The general formula is
Annual amount to be depreciated =
A machine costing $10,000, with an estimated salvage value of $0 and an estimated life of
10 years, would be depreciated at the rate of $1,000 per year for each of the 10 years. If its
estimated salvage value at the end of the 10 years is $1,000, the annual depreciation charge is
$10,000 $1,000
= $900
10
SUM-OF-THE-YEARS-DIGITS (SYD) METHOD
The purpose of the SYD method is to reduce the book value of an asset rapidly in early years
and at a lower rate in the later years of its life.
Suppose that the estimated useful life is five years. The numbers add up to 15:
1 + 2 + 3 + 4 + 5 = 15. Therefore, we depreciate the asset by 5 15 after the first year,
4 15 after the second year, and so on, down to 1 15 in the last year.
DECLINING-BALANCE METHOD
This method also achieves an accelerated depreciation. The assets value is decreased by
reducing its book value by a constant percentage each year. The percentage rate selected is
often the one that just reduces book value to salvage value at the end of the assets estimated life. In any case, the asset should never be reduced below estimated salvage value.
Use of the declining-balance method and allowable rates are controlled by Internal
Revenue Service regulations. As a simplified illustration, the preceding example is used in
the next table with an arbitrarily selected rate of 40 percent. Note that depreciation is based
on full cost, not cost minus salvage value.
YEAR
DEPRECIATION
RATE
BEGINNING
BOOK VALUE
DEPRECIATION
CHARGE
ACCUMULATED
DEPRECIATION
ENDING
BOOK VALUE
$10,200
0.40
$17,000
$6,800
$ 6,800
0.40
10,200
4,080
10,880
6,120
0.40
6,120
2,448
13,328
3,672
0.40
3,672
1,469
14,797
2,203
2,203
203
15,000
2,000
In the fifth year, reducing book value by 40 percent would have caused it to drop below
salvage value. Consequently, the asset was depreciated by only $203, which decreased book
value to salvage value.
DOUBLE-DECLINING-BALANCE METHOD
Again, for tax advantages, the double-declining-balance method offers higher depreciation
early in the life span. This method uses a percentage twice the straight line for the life span of
the item but applies this rate to the undepreciated original cost. The method is the same as the
declining-balance method, but the term double-declining balance means double the straightline rate. Thus, equipment with a 10-year life span would have a straight-line depreciation
rate of 10 percent per year, and a double-declining-balance rate (applied to the undepreciated
amount) of 20 percent per year.
DEPRECIATION-BY-USE METHOD
The purpose of this method is to depreciate a capital investment in proportion to its use. It
is applicable, for example, to a machine that performs the same operation many times. The
life of the machine is estimated not in years but rather in the total number of operations it
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may reasonably be expected to perform before wearing out. Suppose that a metal-stamping
press has an estimated life of one million stamps and costs $100,000. The charge for depreciation per stamp is then $100,000 1,000,000, or $0.10. Assuming a $0 salvage value, the
depreciation charges are as shown in the following table:
YEAR
TOTAL YEARLY
STAMPS
COST PER
STAMP
YEARLY
DEPRECIATION
CHARGE
ACCUMULATED
DEPRECIATION
ENDING
BOOK VALUE
150,000
0.10
$15,000
$ 15,000
$85,000
300,000
0.10
30,000
45,000
55,000
200,000
0.10
20,000
65,000
35,000
200,000
0.10
20,000
85,000
15,000
100,000
0.10
10,000
95,000
5,000
50,000
0.10
5,000
100,000
ACTIVITY-BASED COSTING
To know how much it costs to make a certain product or deliver a service, some method of
allocating overhead costs to production activities must be applied. The traditional approach is
to allocate overhead costs to products on the basis of direct labor dollars or hours. By dividing the total estimated overhead costs by total budgeted direct labor hours, an overhead rate
can be established. The problem with this approach is that direct labor as a percentage of total
costs has fallen dramatically over the past decade. For example, introduction of advanced
manufacturing technology and other productivity improvements has driven direct labor to as
low as 7 to 10 percent of total manufacturing costs in many industries. As a result, overhead
rates of 600 percent or even 1,000 percent are found in some highly automated plants.
This traditional accounting practice of allocating overhead to direct labor can lead to
questionable investment decisions; for example, automated processes may be chosen over
labor-intensive processes based on a comparison of projected costs. Unfortunately, overhead
does not disappear when the equipment is installed, and overall costs may actually be lower
with the labor-intensive process. It can also lead to wasted effort because an inordinate
amount of time is spent tracking direct labor hours. For example, one plant spent 65 percent
of computer costs tracking information about direct labor transactions even though direct
labor accounted for only 4 percent of total production costs.1
Activity-based costing techniques have been developed to alleviate these problems by
refining the overhead allocation process to more directly reflect actual proportions of overhead consumed by the production activity. Causal factors, known as cost drivers, are identified and used as the means for allocating overhead. These factors might include machine
hours, beds occupied, computer time, flight hours, or miles driven. The accuracy of overhead allocation, of course, depends on the selection of appropriate cost drivers.
Activity-based costing involves a two-stage allocation process, with the first stage assigning overhead costs to cost activity pools. These pools represent activities such as performing
machine setups, issuing purchase orders, and inspecting parts. In the second stage, costs are
assigned from these pools to activities based on the number or amount of pool-related activity required in their completion. Exhibit SB.2 compares traditional cost accounting and
activity-based costing.
Consider the example of activity-based costing in Exhibit SB.3. Two products, A and B,
are produced using the same number of direct labor hours. The same number of direct labor
hours produces 5,000 units of Product A and 20,000 units of Product B. Applying traditional costing, identical overhead costs would be charged to each product. By applying
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supplement B
EXHIBIT SB.2
Traditional Costing
Activity-Based Costing
Total overhead
Total overhead
Labor-hour allocation
Cost pools
Cost-driver allocation
EXHIBIT SB.3
BASIC DATA
EVENTS OF TRANSACTIONS
ACTIVITY
TRACEABLE
COSTS
TOTAL
PRODUCT A
PRODUCT B
Machine setups
$230,000
5,000
3,000
2,000
Quality inspections
160,000
8,000
5,000
3,000
Production orders
81,000
600
200
400
Machine-hours worked
314,000
40,000
12,000
28,000
Material receipts
90,000
750
150
600
25,000
5,000
20,000
$875,000
OVERHEAD RATES BY ACTIVITY
ACTIVITY
(a)
TRACEABLE
COSTS
Machine setups
(a) (b)
RATE PER EVENT
OR TRANSACTION
(b)
TOTAL EVENTS
OR TRANSACTIONS
$230,000
5,000
$46/setups
Quality inspections
160,000
8,000
$20/inspection
Production orders
81,000
600
$135/order
Machine-hours worked
314,000
40,000
$7.85/hour
Material receipts
90,000
750
$120/receipt
PRODUCT B
EVENTS OR
EVENTS OR
TRANSACTIONS
AMOUNT
TRANSACTIONS
AMOUNT
3,000
$138,000
2,000
$ 92,000
5,000
100,000
3,000
60,000
200
27,000
400
54,000
12,000
94,200
28,000
219,800
18,000
600
150
72,000
$377,200
$497,800
5,000
20,000
$75.44
$24.89
SEE R. GARRISON, MANAGERIAL ACCOUNTING, 10TH ED. (NEW YORK: MCGRAW-HILL, 2002).
Overhead Allocations by
an Activity Approach
715
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activity-based costing, traceable costs are assigned to specific activities. Because each product required a different amount of transactions, different overhead amounts are allocated to
these products from the pools.
As stated earlier, activity-based costing overcomes the problem of cost distortion by creating a cost pool for each activity or transaction that can be identified as a cost driver, and
by assigning overhead cost to products or jobs on a basis of the number of separate activities
required for their completion. Thus, in the previous situation, the low-volume product would
be assigned the bulk of the costs for machine setup, purchase orders, and quality inspections, thereby showing it to have high unit costs compared to the other product.
Finally, activity-based costing is sometimes referred to as transactions costing. This
transactions focus gives rise to another major advantage over other costing methods: It improves the traceability of overhead costs and thus results in more accurate unit cost data
for management.
THE EFFECTS
OF
TA X E S
Tax rates and the methods of applying them occasionally change. When analysts evaluate
investment proposals, tax considerations often prove to be the deciding factor because depreciation expenses directly affect taxable income and therefore profit. The ability to write off
depreciation in early years provides an added source of funds for investment. Before 1986,
firms could employ an investment tax credit, which allowed a direct reduction in tax liability. But tax laws change, so it is crucial to stay on top of current tax laws and try to predict
future changes that may affect current investments and accounting procedures.
CHOOSING
AMONG
INVESTMENT PROPOSALS
The capital investment decision has become highly rationalized, as evidenced by the variety of techniques available for its solution. In contrast to pricing or marketing decisions,
the capital investment decision can usually be made with a higher degree of confidence
because the variables affecting the decision are relatively well known and can be quantified with fair accuracy.
Investment decisions may be grouped into six general categories:
1
2
3
4
5
6
Investment decisions are made with regard to the lowest acceptable rate of return on
investment. As a starting point, the lowest acceptable rate of return may be considered to be
the cost of investment capital needed to underwrite the expenditure. Certainly an investment will not be made if it does not return at least the cost of capital.
Investments are generally ranked according to the return they yield in excess of their cost
of capital. In this way, a business with only limited investment funds can select investment
alternatives that yield the highest net returns. (Net return is the earnings an investment
yields after gross earnings have been reduced by the cost of the funds used to finance the
investment.) In general, investments should not be made unless the return in funds exceeds
the marginal cost of investment capital. (Marginal cost is the incremental cost of each new
acquisition of funds from outside sources.)
DETERMINING
THE
COST
OF
C A P I TA L
The cost of capital is calculated from a weighted average of debt and equity security costs. This
average will vary depending on the financing strategy employed by the company. The most
common sources of financing are short-term debt, long-term debt, and equity securities. A
bank loan is an example of short-term debt. Bonds normally provide long-term debt. Finally,
stock is a common form of equity financing. In the following, we give a short example of each
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form of financing, and then show how they are combined to find the weighted average cost
of capital.
The cost of short-term debt depends on the interest rate on the loan and whether the loan
is discounted. Remember that interest is a tax-deductible expense for a company.
Cost of short-term debt =
Interest paid
Proceeds received
If a bank discounts a loan, interest is deducted from the face of the loan to get the proceeds.
When a compensating balance is required (that is, a percentage of the face value of the loan
is held by the bank as collateral), proceeds are also reduced. In either case, the effective
or real interest rate on the loan is higher than the face interest rate owing to the proceeds
received from the loan being less than the amount (face value) of the loan.
EXAMPLE OF SHORT-TERM DEBT
A company takes a $150,000, one-year, 13 percent loan. The loan is discounted, and a 10 percent compensating balance is required. The effective interest rate is computed as follows:
13% $150,000
$19,500
=
= 16.89%
$115,500
$115,500
Proceeds received equal
Face of loan
$150,000
Less interest
(19,500)
(15,000)
Proceeds
$115,500
Notice how the effective cost of the loan is significantly greater than the stated interest rate.
Long-term debt is normally provided through the sale of corporate bonds. The real cost of
bonds is obtained by computing two types of yield: simple (face) yield and yield to maturity (effective interest rate). The first involves an easy approximation, but the second is
more accurate. The nominal interest rate equals the interest paid on the face (maturity value)
of the bond and is always stated on a per-annum basis. Bonds are generally issued in $1,000
denominations and may be sold above face value (at a premium) or below (at a discount,
termed original issue discount, or OID). A bond is sold at a discount when the interest rate
is below the going market rate. In this case, the yield will be higher than the nominal interest rate. The opposite holds for bonds issued at a premium.
The issue price of a bond is the par (or face value) times the premium (or discount).
Simple yield =
Nominal interest
Issue price of bond
Nominal interest +
Yield to maturity =
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12% $400,000
$48,000
=
= 12.4%
97% $400,000
$388,000
$12,000
$48,000 + $1,200
10
= 12.5%
=
Yield to maturity =
$388,000 + $400,000
$394,000
2
$48,000 +
Note that because the bonds were sold at a discount, the yield exceeds the nominal interest
rate (12 percent). Bond interest is tax deductible to the corporation.
The actual cost of equity securities (stocks) comes in the form of dividends, which are not
tax deductible to the corporation.
Cost of common stock =
Here the value per share equals the market price per share minus flotation costs (that is, the
cost of issuing securities, such as brokerage fees and printing costs). It should be noted that
this valuation does not consider what the investor expects in market price appreciation.
This expectation is based on the expected growth in earnings per share and the relative
risk taking by purchasing the stock. The capital asset pricing model (CAPM) can be used to
capture this impact.2
EXAMPLE OF THE COST OF COMMON STOCK
A companys dividend per share is $10, net value is $70 per share, and the dividend growth
rate is 5 percent.
Cost of the stock =
$10
+ 0.05 = 19.3%
$70
To compute the weighted average cost of capital, we consider the percentage of the total capital that is being provided by each financing alternative. We then calculate the after-tax cost
of each financing alternative. Finally, we weight these costs in proportion to their use.
EXAMPLE OF CALCULATING THE WEIGHTED AVERAGE COST OF CAPITAL
Consider a company that shows the following figures in its financial statements:
Short-term bank loan (13%)
$1 million
$4 million
$5 million
For our example, assume that each of the percentages given above represents the cost of
the source of capital. In addition to the above, we need to consider the tax rate of the firm
because the interest paid on the bonds and on the short-term loan is tax deductible. Assume
a corporate tax rate of 40 percent.
PERCENT
AFTER-TAX COST
WEIGHTED
AVERAGE COST
10%
.78%
Bonds payable
40%
3.84%
Common stock
50%
10%
Total
100%
5%
9.62%
Keep in mind that in developing this section we have made many assumptions in these
calculations. When these ideas are applied to a specific company, many of these assumptions may change. The basic concepts, though, are the same; keep in mind that the goal is to
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simply calculate the after-tax cost of the capital used by the company. We have shown the
cost of capital for the entire company, though often only the capital employed for a specific
project is used in the calculation.
I N T E R E ST R AT E E F F E C T S
There are two basic ways to account for the effects of interest accumulation. One is to compute the total amount created over the time period into the future as the compound value. The
other is to remove the interest rate effect over time by reducing all future sums to presentday dollars, or the present value.
C o m p o u n d V a l u e o f a S i n g l e A m o u n t Albert Einstein was quoted as saying that compound interest is the eighth wonder of the world. After reviewing this section
showing compound interests dramatic growth effects over a long time, you might wish to
propose a new government regulation: On the birth of a child, the parents must put, say,
$1,000 into a retirement fund for that child, available at age 65. This might reduce the pressure on Social Security and other state and federal pension plans. Although inflation would
decrease the value significantly, there would still be a lot left over. At 14 percent return on
investment, our $1,000 would increase to $500,000 after subtracting the $4.5 million for
inflation. That is still a 500-fold increase. (Many mutual funds today have long-term performances in excess of 14 percent per year.)
Spreadsheets and calculators make such computation easy. The box titled Using a
Spreadsheet shows the most useful financial functions. However, many people still refer
to tables for compound values. Using Appendix G, Table G.1 (compound sum of $1), for
example, we see that the value of $1 at 10 percent interest after three years is $1.331. Multiplying this figure by $10 gives $13.31.
C o m p o u n d V a l u e o f a n A n n u i t y An annuity is the receipt of a constant sum
each year for a specified number of years. Usually an annuity is received at the end of a
period and does not earn interest during that period. Therefore, an annuity of $10 for three
years would bring in $10 at the end of the first year (allowing the $10 to earn interest if
invested for the remaining two years), $10 at the end of the second year (allowing the $10
to earn interest for the remaining one year), and $10 at the end of the third year (with no time
to earn interest). If the annuity receipts were placed in a bank savings account at 5 percent
interest, the total or compound value of the $10 at 5 percent for the three years would be
YEAR
RECEIPT AT END
OF YEAR
COMPOUND INTEREST
FACTOR (1 + i)n
VALUE AT END
YEAR
$10.00
(1 + 0.05)2
$11.02
10.00
(1 + 0.05)1
10.50
10.00
(1 + 0.05)0
10.00
OF THIRD
$31.52
supplement B
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USING A SPREADSHEET
We hope that you are all doing these calculations using a
spreadsheet program. Even though the computer makes these
calculations simple, it is important that you understand what
the computer is actually doing. Further, you should check your
calculations manually to make sure that you have the formulas
set up correctly in your spreadsheet. There are many stories of
the terrible consequences of making a wrong decision based
on a spreadsheet with errors!
For your quick reference, the following are the financial functions you will find most useful. These are from the Microsoft
Excel help screens.
PV (rate, nper, pmt)Returns the present value of an investment. The present value is the total amount that a series of
future payments is worth now. For example, when you borrow
money, the loan amount is the present value to the lender.
Rate is the interest rate per period. For example, if you obtain
an automobile loan at a 10 percent annual interest rate and
make monthly payments, your interest rate per month is
10%/12, or .83%. You would enter 10%/12, or .83%, or .0083, in
the formula as the rate. Nper is the total number of payment
periods in an annuity. For example, if you get a four-year car
loan and make monthly payments, your loan has 4*12 (or 48)
periods. You would enter 48 into the formula for nper. Pmt is
the payment made each period and cannot change over the
life of the annuity. Typically, this includes principal and interest but no other fees or taxes. For example, the monthly
payment on a $10,000, four-year car loan at 12 percent is
$263.33. You would enter 263.33 into the formula as pmt.
In Appendix G, Table G.2 lists the compound value factor of $1 for 5 percent after three
years as 3.152. Multiplying this factor by $10 yields $31.52.
In a fashion similar to our previous retirement investment example, consider the beneficial effects of investing $2,000 each year, just starting at the age of 21. Assume investments
in AAA-rated bonds are available today yielding 9 percent. From Table G.2 in Appendix G,
after 30 years (at age 51) the investment is worth 136.3 times $2,000, or $272,600. Fourteen years later (at age 65) this would be worth $963,044 (using a hand calculator, because
the table goes only to 30 years, and assuming the $2,000 is deposited at the end of each
year)! But what 21-year-old thinks about retirement?
P r e s e n t V a l u e o f a F u t u r e S i n g l e P a y m e n t Compound values are used
to determine future value after a specific period has elapsed; present value (PV) procedures
accomplish just the reverse. They are used to determine the current value of a sum or stream
of receipts expected to be received in the future. Most investment decision techniques use present value concepts rather than compound values. Because decisions affecting the future are
made in the present, it is better to convert future returns into their present value at the time the
decision is being made. In this way, investment alternatives are placed in better perspective in
terms of current dollars.
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An example makes this more apparent. If a rich uncle offers to make you a gift of $100
today or $250 after 10 years, which should you choose? You must determine whether the
$250 in 10 years will be worth more than the $100 now. Suppose that you base your decision on the rate of inflation in the economy and believe that inflation averages 10 percent
per year. By deflating the $250, you can compare its relative purchasing power with $100
received today. Procedurally, this is accomplished by solving the compound formula for the
present sum, P, where V is the future amount of $250 in 10 years at 10 percent. The compound value formula is
V = P(1 + i)n
Dividing both sides by (1 + i)n gives
P=
=
V
(1 + i)n
250
= $96.39
(1 + 0.10)10
This shows that, at a 10 percent inflation rate, $250 in 10 years will be worth $96.39 today.
The rational choice, then, is to take the $100 now.
The use of tables is also standard practice in solving present value problems. With reference to Appendix G, Table G.3, the present value factor for $1 received 10 years hence is
0.386. Multiplying this factor by $250 yields $96.50.
P r e s e n t V a l u e o f a n A n n u i t y The present value of an annuity is the value of
an annual amount to be received over a future period expressed in terms of the present. To
find the value of an annuity of $100 for three years at 10 percent, find the factor in the present value table that applies to 10 percent in each of the three years in which the amount is
received and multiply each receipt by this factor. Then sum the resulting figures. Remember that annuities are usually received at the end of each period.
YEAR
AMOUNT RECEIVED
AT END OF YEAR
PRESENT VALUE
FACTOR AT 10%
PRESENT
VALUE
$100
0.909
$ 90.90
100
0.826
82.60
100
0.751
75.10
$248.60
Total receipts
$300
1
1
1
+
+ +
(1 + i) (1 + i)2
(1 + i)n
where
An = Present value of an annuity of n years
R = Periodic receipts
n = Length of the annuity in years
Applying the formula to the preceding example gives
An = $100
1
1
1
+
+
2
(1 + 0.10) (1 + 0.10)
(1 + 0.10)3
= $100(2.487) = $248.70
supplement B
721
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supplement B
Page 722
FINANCIAL ANALYSIS
In Appendix G, Table G.4 contains present values of an annuity for varying maturities.
The present value factor for an annuity of $1 for three years at 10 percent (from Appendix G,
Table G.4) is 2.487. Given that our sum is $100 rather than $1, we multiply this factor by
$100 to arrive at $248.70.
When the stream of future receipts is uneven, the present value of each annual receipt
must be calculated. The present values of the receipts for all years are then summed to arrive
at total present value. This process can sometimes be tedious, but it is unavoidable.
D i s c o u n t e d C a s h F l o w The term discounted cash flow refers to the total stream of
payments that an asset will generate in the future discounted to the present time. This is simply present value analysis that includes all flows: single payments, annuities, and all others.
METHODS
OF
RANKING INVESTMENTS
ALTERNATIVE A
ALTERNATIVE B
$10,000
$15,000
10,000
15,000
10,000
15,000
10,000
15,000
10,000
15,000
To choose between Alternatives A and B, find which has the highest net present value.
Assume an 8 percent cost of capital.
ALTERNATIVE A
ALTERNATIVE B
Investment A is the better alternative. Its net present value exceeds that of Investment B by
$35 ($9,930 $9,895 = $35).
P a y b a c k P e r i o d The payback method ranks investments according to the time
required for each investment to return earnings equal to the cost of the investment. The
rationale is that the sooner the investment capital can be recovered, the sooner it can be reinvested in new revenue-producing projects. Thus, supposedly, a firm will be able to get the
most benefit from its available investment funds.
Consider two alternatives requiring a $1,000 investment each. The first will earn $200 per
year for six years; the second will earn $300 per year for the first three years and $100 per
year for the next three years.
If the first alternative is selected, the initial investment of $1,000 will be recovered at the
end of the fifth year. The income produced by the second alternative will total $1,000 after
only four years. The second alternative will permit reinvestment of the full $1,000 in new
revenue-producing projects one year sooner than the first.
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FINANCIAL ANALYSIS
Though the payback method is declining in popularity as the sole measure in investment
decisions, it is still frequently used in conjunction with other methods to indicate the time
commitment of funds. The major problems with payback are that it does not consider
income beyond the payback period and it ignores the time value of money. A method that
ignores the time value of money must be considered questionable.
I n t e r n a l R a t e o f R e t u r n The internal rate of return may be defined as the interest rate that equates the present value of an income stream with the cost of an investment.
There is no procedure or formula that may be used directly to compute the internal rate of
returnit must be found by interpolation or iterative calculation.
Suppose we wish to find the internal rate of return for an investment costing $12,000
that will yield a cash inflow of $4,000 per year for four years. We see that the present value
factor sought is
$12,000
= 3.000
$4,000
and we seek the interest rate that will provide this factor over a four-year period. The interest rate must lie between 12 and 14 percent because 3.000 lies between 3.037 and 2.914
(in the fourth row of Appendix G, Table G.4). Linear interpolation between these values,
according to the equation
I = 12 + (14 12)
(3.037 3.000)
(3.037 2.914)
= 12 + 0.602 = 12.602%
gives a good approximation to the actual internal rate of return.
When the income stream is discounted at 12.6 percent, the resulting present value closely
approximates the cost of investment. Thus the internal rate of return for this investment is
12.6 percent. The cost of capital can be compared with the internal rate of return to determine the net rate of return on the investment. If, in this example, the cost of capital were
8 percent, the net rate of return on the investment would be 4.6 percent.
The net present value and internal rate of return methods involve procedures that are
essentially the same. They differ in that the net present value method enables investment
alternatives to be compared in terms of the dollar value in excess of cost, whereas the internal
rate of return method permits comparison of rates of return on alternative investments. Moreover, the internal rate of return method occasionally encounters problems in calculation, as
multiple rates frequently appear in the computation.
R a n k i n g I n v e s t m e n t s w i t h U n e v e n L i v e s When proposed investments
have the same life expectancy, comparison among them, using the preceding methods, will
give a reasonable picture of their relative value. When lives are unequal, however, there is
the question of how to relate the two different time periods. Should replacements be considered the same as the original? Should productivity for the shorter-term unit that will be
replaced earlier be considered higher? How should the cost of future units be estimated?
No estimate dealing with investments unforeseen at the time of decision can be expected to reflect a high degree of accuracy. Still, the problem must be dealt with, and some
assumptions must be made in order to determine a ranking.
supplement B
723
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Page 724
FINANCIAL ANALYSIS
cost estimates based on an annual increased output of 100,000 bricks:
Cost of new equipment having an expected life of five years
$500,000
20,000
40,000
40,000
160,000
400,000
The sum-of-the-years-digits method of depreciation will be used, and taxes are paid at a rate of
40 percent. Wilsons policy is not to invest capital in projects earning less than a 20 percent rate of
return. Should the proposed expansion be undertaken?
SOLUTION
Compute the cost of investment:
Acquisition cost of equipment
$500,000
20,000
$520,000
PROPORTION OF $500,000
TO BE DEPRECIATED
1
2
3
4
5
5/15 $500,000
4/15 500,000
3/15 500,000
2/15 500,000
1/15 500,000
DEPRECIATION
CHARGE
=
=
=
=
=
$ 166,667
133,333
100,000
66,667
33,333
Accumulated depreciation
$500,000
Find each years cash flow when taxes are 40 percent. Cash flow for only the first year is illustrated:
Earnings before depreciation and taxes
$400,000
Deduct: Taxes at 40% (40% 400,000)
$160,000
93,333
Tax benefit of depreciation expense (0.4 166,667)
66,667
Cash flow (first year)
$306,667
Determine the present value of the cash flow. Because Wilson demands at least a 20 percent rate
of return on investments, multiply the cash flows by the 20 percent present value factor for each year.
The factor for each respective year must be used because the cash flows are not an annuity.
YEAR
PRESENT VALUE
FACTOR
0.833
0.694
0.579
0.482
0.402
CASH FLOW
PRESENT VALUE
=
$255,454
293,333
203,573
280,000
162,120
266,667
128,533
253,334
101,840
$851,520
$306,667
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FINANCIAL ANALYSIS
Now find whether net present value is positive or negative:
Total present value of cash flows
$851,520
520,000
$331,520
Net present value is positive when returns are discounted at 20 percent. Wilson will earn an amount
in excess of 20 percent on the investment. The proposed expansion should be undertaken.
SOLUTION
Determine the cost of investment:
Price of the new machine
Less: Sale of old machine
Avoidable overhaul costs
Effective cost of investment
$6,000
$2,000
300
2,300
$3,700
Determine the increase in cash flow resulting from investment in the new machine:
Yearly cost savings = $1,200
Differential depreciation
Annual depreciation on old machine:
Cost Salvage $4,000 $0
= = $400
Expected life
10
Annual depreciation on new machine:
Cost Salvage $6,000 $500
= = $1,100
Expected life
5
Differential depreciation = $1,100 $400 = $700
Yearly net increase in cash flow into the firm:
Cost savings
$1,200
Deduct: Taxes at 40%
$480
Add: advantage of increase in
depreciation (0.4 $700)
280
200
Yearly increase in cash flow
$1,000
Determine total present value of the investment:
The five-year cash flow of $1,000 per year is an annuity.
Discounted at 12 percent, the cost of capital, the present value is
3.605 $1,000 = $3,605
The present value of the new machine, if sold at its salvage value of $500 at the end of
the fifth year, is
0.567 $500 = $284
Total present value of the expected cash flows is
$3,605 + $284 = $3,889
supplement B
725
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supplement B
Page 726
FINANCIAL ANALYSIS
Determine whether net present value is positive:
Total present value
$3,889
Cost of investment
3,700
$189
Bennies Brewery should make the purchase because the investment will return slightly more than
the cost of capital.
Note: The importance of depreciation has been shown in this example. The present value of the
yearly cash flow resulting from operations is
(Cost savings Taxes) (Present value factor)
($1,200 $480)
(3.605)
= $2,596
This figure is $1,104 less than the $3,700 cost of the investment. Only a very large depreciation advantage makes this investment worthwhile. The total present value of the advantage is $1,009:
(Tax rate Differential depreciation) (PV factor)
(0.4 $700)
(3.605) = $1,009
SOLUTION
Find the total cost incurred if the part were manufactured:
$ 50,000
125,000
600,000
60,000
$835,000
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FINANCIAL ANALYSIS
supplement B
727
SELECTED BIBLIOGRAPHY
Bodie, Z.; A. Kane; and A. Marcus. Investments. 3rd ed. Burr Ridge, IL:
Richard D. Irwin, 1996.
FOOTNOTES
1 T. Johnson and R. Kaplan, Relevance Lost: The Rise and Fall of Management Accounting (Boston: Harvard Business School
Press, 1987), p. 188.
2 A description of capital asset pricing is included in many finance textbooks; see, for example, Z. Bodie, A. Kane, and A. Marcus,
Investments, 3rd ed. (Burr Ridge, IL: Richard D. Irwin, 1996), pp. 23665.